Selling your funds to avoid cap gains

CBS.MarketWatch.com

Editor's Note: Got a question about Mutual Funds? MarketWatch reporter Craig Tolliver, who regularly writes our column, will try to find answers to as many as possible. Send your questions to Keep in mind these comments aren't intended as a substitute for advice from a financial professional familiar with your circumstances.

Do I have to pay taxes when I take money out of my mutual fund? It is not an IRA. I pay the tax each year on my capital gains. Should I take $2,000 out each year and put it in a Roth IRA to avoid some of the cap gain tax or should I just leave it until I need it? I'm 53 and not planning to start taking out until my 60's. --Donna

CBSMW: If the money that you remove from your mutual fund shows a profit, then yes, you would be liable for income tax on that profit.

"Based on the individual
mutual fund?s history of making distributions, this may or may not be a big
advantage."
Stewart H. Welch, The Welch Group

"When you sell shares of a mutual fund, you will either realize tax gains or losses. The gain is computed on the difference between the sales price (the amount you redeem out of your mutual fund) and your basis on those shares. The basis is computed as the amount you paid for the shares through direct purchase and reinvestment of dividends, interest and capital gains," explains Stewart H. Welch, III, founder of wealth management firm, The Welch Group, and author of "J.K. Lasser's Estate Planning for Baby Boomers and Retirees."

Further, gains and losses on shares held less than 12 months are considered short-term and subject to ordinary income tax rates while shares held over 12 months are subject to the lower long-term tax rates.

The capital gains tax that you pay every year is, of course, a separate issue. These taxes reflect distributions from the fund that you've either received directly or most likely had reinvested.

To answer your question, Welch makes two assumptions. First, that your tax rates don?t change after you retire, and second, that you earn the same rate of return on either investment.

"Based on these assumptions, the only advantage to paying taxes on the sale of your taxable mutual fund and investing in a Roth is that the mutual fund capital gains distributions inside the Roth IRA would never be subject to income taxes. Based on the individual mutual fund?s history of making distributions, this may or may not be a big advantage," says Welch.

Simply put, if the gains are regularly quite high, it might pay to move the fund into your Roth to save on the distribution. If, however, the gains are normally low, it may not be worth the bother. If this is a move that you're strongly considering, it would probably be best to sit down with a financial advisor who can take your entire financial situation into consideration.

Also,if you think that this might be money that you will never touch and will leave to your heirs, leaving it in the taxable account might be a wise move in planning your estate.

"Let's say that you bought IBM for a dollar and today it is worth $100. So if you were to sell it today, you would have $99 subject to long-term capital gains," Welch illustrates. "If you die tomorrow, what the law says is that you're going to get a stepped-up cost basis on that money. This means that if your heir sells the IBM shares the day after your death, it's as if you had paid $100 for it instead of the original dollar. It's a pretty big deal for the money that you're not going to use. It's a pretty substantial advantage for holding the money in the taxable account vs. selling it, paying the tax now and putting it into a Roth."

For regular monthly investing programs, are there some funds or fund classes which are more appropriate for dollar-cost averaging than others? I am a 55-year-old physician with a fully funded pension plan. I earn a lot more than I spend and I am investing monthly in a variety of funds with the hope of being somewhat diversified. My current monthly investment portfolio includes Janus Global Technology, Janus Strategic Value, Longleaf Realty, Fidelity OTC, and Vanguard Growth Index. I plan to retire in around 10 years. Thus these non-pension plan investments are long term and I can afford fairly volatile higher-risk investments. --Richard

It's probably the most volatile funds in your portfolio, however, where the advantages of dollar-cost averaging are the most recognizable.

Dollar-cost averaging is an investment strategy in which you invest a fixed sum at regular intervals, which lowers the risk or volatility of your investment by reducing the average cost to the investor.

It's an investment strategy that should be familiar to anyone that invests in a 401(k) plan.

"The same sum purchases more shares when the NAV (net asset value) of a fund is lower and fewer shares when it is higher," explains Frank.

Since you have the security of a fully funded pension as the core of your retirement portfolio, Frank agrees that you have a greater opportunity to diversify into funds that are more speculative than would someone who needs consistent income from a given fund source.

"You know your time horizon and risk tolerance. You need to define your investment goals," advises Frank. "And you may also want to look at your overall asset allocation -- what percentage of your investments are in stocks vs. bonds, and within that, what kinds of stocks and what kinds of bonds -- before you decide where to invest the monthly fixed sum."

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